This post comes to us from George Dallas, Director of Corporate Governance at F&C Management Ltd., and is based on a concept paper prepared by F&C Management.

In the aftermath of the recent financial crisis, bank remuneration remains a critically sensitive issue – for shareholders, creditors, regulators, governments and the general public. This is particularly the case for those systemically important financial institutions that received government bailouts. While many of these institutions are beginning to recover, the negative effects of increased debt taken on at the public sector level to protect the financial system have resulted in serious and lingering economic problems in many countries, including the UK and the US. Indeed, the impact of public sector balance sheets absorbing losses of the banking sector has had the after-effect of contributing to sovereign debt crises in several smaller European jurisdictions — which continue to plague investors, taxpayers and the wider economy.

In this context, the legitimacy of granting substantial bonus awards to executives of systemically important banks — particularly those that have benefited from the state as a provider of financial support — is continuously, and fairly, called into question. While often played out in the media in a sensational or populist manner, this is a serious concern that calls for a fundamental rethink.

There are no easy answers. To compete in a complex environment, rebuild financial strength and wean themselves from state support, banks need to be able to attract and retain capable managers in a competitive marketplace for executive talent. We appreciate this as investors, and recognise that the ability to pay competitive salaries and to grant fairly-earned bonuses is a commercial necessity.

At the same time we believe that remuneration structures in banks generally remain problematic, and that even broad regulatory reform frameworks, such as the G20 Principles and the more recent FSA Remuneration Guidelines, have not resolved all the outstanding concerns. We are generally discouraged by the inability of banks to work together to show restraint in the area of pay, and believe that even with many remuneration reforms that have been put into place bank remuneration, in particular the granting of bonuses, will continue to be an area of controversy.

Bank Remuneration and Moral Hazard

Specifically, we still have not cracked the asymmetry of reward problem sufficiently with banks. In good times bankers are set to make fortunes both at executive and below board levels of the organization; in severely bad times the state — and ultimately the tax payer — foots the bill because of their systemic importance to the economy. This moral hazard issue is a particular feature of the financial sector [1], and is why, in part, we have seen specific attempts (including the Walker Review and the recent European Commission Green Paper) to frame corporate governance issues specifically for this sector. A key point of differentiation is that for systemically important banks, where the state is an implicit guarantor because of the “too big to fail” concern, it is critically important that banks manage themselves to avoid not only default in the extreme, but also a meaningful deterioration of their standalone credit quality that could result significant operational and financial impacts. That has to be job one, and incentive systems must encourage this. [2]

In this context we have seen balanced scorecards in remuneration schemes at banks calling for improvements in risk management and bank credit quality as key performance indicators. While this is positive and laudable, it is even more important that remuneration schemes provide incentives for banks to avoid material deterioration of credit quality — a focus on the downside, not the upside. This is obviously a concern of creditors, but it is also a concerned shared by shareholders, particularly in the case of banks, where funding costs and funding stability are critical to the long-term sustainability and value creation of the enterprise.

Credit Quality as a Binding Constraint for Bonus Payouts

Hence, an idea to explore with large banks: establish the maintenance of a minimum standard of credit quality as an underpin – or precondition – to bonus awards. The starting point would be to define a base level of acceptable credit quality. If these credit quality standards are met, then bonus payments could be paid – in accordance with other guiding performance metrics (e.g. economic profit, earnings growth, share price, total shareholder return (TSR), strategic metrics, etc). If credit quality standards are not met, then a bonus payment is not justified, even if other performance criteria are satisfied. This would most likely apply to executive management, who are accountable for the health of the bank as a whole, and probably not to company managers focused only on one division of the bank.

Details of measuring credit quality require some thought, but this should be workable and measurable. A non-exhaustive list of possible metrics that could be used either on a standalone basis, or jointly with other metrics, includes the following: credit ratings [3], credit default swap spreads [4], the bank’s cost of capital, Basel III capital ratios or the level/growth of non-core liabilities in the bank’s funding mix. [5] The threshold for such an underpin could be established sufficiently below the bank’s existing credit standing to provide some degree of cushion from slight changes in credit quality, but would be a safeguard against a wholesale credit deterioration. It would be important for the credibility of such a credit metric to be objective and independent — and not simply reflections of the bank’s own risk management systems.

Conclusion

Establishing credit quality as an underpin for bonus awards would mean that systemically important banks will reward executives for profitability and value creation for shareholders only if the bank’s credit profile is not put at undue risk. While clawbacks/malus already exist for extreme situations, those are “nuclear” deterrents that no one wants to see exercised. By having a credit benchmark as a backstop, there is an additional layer of protection — and an additional incentive for systemically important banks to manage their risks responsibly.

We believe that this form of incentive discipline has economic legitimacy, and could contribute to investor support of bank remuneration plans in their voting activity. Moreover, by demonstrating that remuneration systems are guarding against the type of downside risks that threaten systemic stability, the inclusion of credit quality as an underpin also stands to be received positively by regulators and broader stakeholders, and will help banks to be forward-looking and defend the granting bonus awards in these still uncertain economic conditions.

Endnotes

[1] It could also extend to non-financial national or regional “champions” that have particular economic importance in other countries or jurisdictions.(go back)

[2] For example, a recent academic paper has encouraged the use of debt instruments as a form of executive remuneration to reinforce a more prudent perspective among its executive managers: see “Inside Debt”, by Alex Edmunds and Qi Liu, The Wharton School, University of Pennsylvania., Oxford University Press, 2010 (available here). In practice, Barclays plc has announced its intention to use contingent capital instruments (“Co-cos”) as executive incentive remuneration, as a way both to build its capital base and provide an incentive for responsible bank stewardship.(go back)

[3] This could relate to the standalone financial strength rating of a bank (e.g. a rating that excludes implicit state support and reflects the contingent liability to the state). While the credibility of credit rating agencies has been under attack for their contribution to the financial crisis, we still believe their ratings could be a useful component of such a performance metric. Credit rating agencies’ main mistakes leading up to the crisis were in the rating of securitizations, not corporate entities. Moreover, credit ratings are less volatile than market sentiments and are established to withstand normal economic cycles and market volatility(go back)

[4] The idea of using credit default swaps in bank remuneration has been proposed in an academic paper: “Executive Compensation and Risk Taking” by Hamid Mehran, Patrick Bolton and Joel Shapiro; paper presented at Columbia University (available here).(go back)

[5] The relationship of non-core liabilities to systemic risk is explored in a recent essay by Hyun Song Shin, Princeton University. “Macroprudential Policies Beyond Basel III”. Winner of the ICFR-FT Research Prize 2010, published by the International Centre for Financial Regulation (available here).(go back)

3 Comments

Transparency is more powerful than regulation. The way to deal with the TBTF organizations is to remove from them more of the privacy rights of individuals and small organizations. Likewise many complex contracts must be banned. As an engineer I think it ludicrous that Wall Street is unable to properly value weak mortgages. William K. Black uses the word “criminogenic” to describe the legal system US Treasury with congress has jumbled together.

The breakdown in underwriting standards was definitely a prime contributing factor, which allowed so much credit risk. This became compounded by various leverage factors (actual and derivative), rating’s systems and other elements. Below is an excerpt from a commentary of mine done in August 2008 on BIS Working Papers. It speaks to credit quality and transparency.

Super Anti-efficiency

“Markets can remain irrational longer than you can remain solvent.” J. M. Keynes.

“The current phenomenon occurring in the capital markets is aptly termed a “dislocation”, as the primary ultimate intermediary—as the process proceeds and as a matter of fact—will be the Central Banks, as proxies for the Sovereign Governments and institutions which they represent.

Efficient Market Hypothesis whether one subscribes or not, concludes that financial markets are “informationally efficient”. The current situation finds: these markets have gotten into their current state due to what might be termed a “super anti-efficiency”—in that data believed known or actionable was either not known or if known not acted upon. To be clear, the statement that the general markets in the main, were unaware and thus became stultified seems reasonable. But please note that in these premises, are included by reference the rules of fiduciary prudence as “should have known” or more importantly, “should have acted upon”.

What is manifest tends toward an abject systemic or asymmetric informational anomaly—coupled with lack of positive and clear-cut action. Was the notional value of “innovative” Credit Risk Transfer instruments and derivatives unknown? Were the off balance sheet operations of investment and commercial banks completely latent? Did Credit Rating Agencies have any semblance of true experiential and subjective understanding of the products being rated? Was the rapid vaporization of Enron not enough of a microcosmic event to warrant extrapolation?

From a subjective and visceral view, everyday actors for example, in Originate & Distribute model businesses and at all levels with the exception of certain investors, knew what was occurring at a daily functional level—however, sans any real understanding of the global-macro consequences. To say the least, the full picture was not widely known or if it was, not disseminated to the participants capable of realization and response.

Central Banks and Sovereign Treasuries, to be able to know and analyze macro consequences,
must have access to accurate information and then the analyses are only as good as the data
collected along with the concomitant ability to analyze, understand and predict distributive results and outcomes.

In the final analysis, most did not perceive the true circumstance—save on an idiosyncratic micro level—and of those who did, either the full consequence was not appreciated or as inheritors, were confronted with an overwhelmingly daunting task. Thus, a condition of Super Anti Efficiency was born.”